Mutual-Fund Investors' Enemy: Themselves

February 28, 2002

By Christopher Farrell The famed value investor Benjamin Graham once remarked, "The investor's chief problem -- and even his worst enemy -- is likely to be himself." No kidding. A recent report penned by Steven Leuthold, a legendary market historian, long-time money manager, and head of Leuthold Group, found that mutual-fund investors did dramatically worse than the overall stock market.

The numbers compiled by DALBAR, a research organization in Boston, are stunning: From 1984 through 2000, the Standard & Poor's 500-stock index showed an average annual return of 16.29%, while the average equity mutual-fund investor realized an annual return of only 5.32%. Imagine, during the greatest bull market in history, mutual-fund investors lagged behind even the annualized return on default-free U.S. Treasury bills of 5.82%.

What accounts for the miserly real return in stock mutual funds? The bulk of the blame for the enormous gap rests with the individual. Investors are far from the rational thinking machines commonly described in finance textbooks. Emotions, fads, and mental biases affect investment decisions. Investors are often far too confident of their stock-picking ability when the market is strong -- and far too depressed about their lack of acumen when it spirals lower.

HERD ON THE STREET. Not to mention the problem of overactive trading. Finance economists have long argued that frequent trading of stocks and mutual funds is hazardous to your wealth. So is paying attention to Wall Street analysts, television touts, mutual-fund timing services, and Web-based stock-pickers.

To put a number on the problem, individuals who frequently traded common stocks at a major discount broker from 1991 through 1996 earned a net annualized return of 11.4%, vs. an 18.5% gain by their less trigger-happy peers, according to research by economists Brad M. Barber of the University of California, Davis and Terrance Odean of UC Berkeley.

And then there's the lure of running with the crowd, such as junk bonds in the late '80s and tech stocks toward the end of the millennium. Barber and Odean found that 54% of the purchases made by more than 32,000 mutual-fund investors through a nationwide discount broker in the early 1990s were of funds in the top performance quintile during the previous year.

Indeed, Leuthold makes a compelling case that the poor results earned by equity-fund investors largely stem from the irresistible urge to chase past performance -- a desire that often sees them piling into the latest hot mutual fund or sector just as the game is ending. Investors also tend to buy when the stock market is high and the economy strong while steering clear of equities when the market is down and the economy faltering -- even though savvy investing requires just the opposite strategy.

"DEVASTATING IMPACT." Many investors also lose their fortitude during a bear market and sell while prices are way down. "Buying at extreme high and selling at extreme lows, be it in the tech sector or in the stock market as a whole, has a devastating impact on a mutual-fund investors' long-term investment results," says Leuthold.

Sure, part of the gulf between mutual-fund investors' returns and the overall market is a result of the costs associated with actively managed mutual funds. Management fees typically run from 1% to 1.35% of assets invested in a fund. And the indirect expense from the market impact of turning over a mutual-fund portfolio, say by 50% a year, adds an additional 0.75% to 1% in cost. Despite all the evidence to the contrary, many mutual-fund investors believe that funds with higher expenses earn above-average returns.

In fact, the average U.S. equity fund has underperformed the S&P 500 by some 160 basis points to 190 basis points annually (a basis point is one one-hundredth of a percent) over the past 15 years.

NOTHING BEATS BUY-AND-HOLD. Mutual-fund investors are constantly reminded that diversification matters, that low fees are preferable to high fees, and that past returns are poor predictors of future returns. And this column has long advocated that nothing beats a buy-and-hold investment strategy with a portfolio composed of broad-based index funds.

Yes, such an approach isn't exactly exciting. But the pleasure of making more money than most of your colleagues at work, even beating the high-priced talent on Wall Street, awaits you if you're willing to endure a little boredom. Not a bad trade-off at all. Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over National Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BusinessWeek Online